Tax Reform: From Risks to Reality
Congress passed the Tax Cuts and Jobs Act (TCJA) on December 20, putting in place the most extensive reform of the U.S. tax code since the mid-1980s under President Ronald Reagan. Following many months of uncertainty, the legislation is expected to be signed into law by President Donald Trump in the coming days.
The TCJA lowers individual tax rates for over 120 million taxpayers while broadening the individual tax base by over $400 billion. It reduces business tax rates substantially, including a cut to the top corporate statutory tax rate to 21 percent from 35 percent.1
The new law heralds change for the muni market. It is likely to shrink the size of the muni market and alter demand for munis from key segments of the buyer base. It is also likely to affect credit fundamentals for states, local governments and hospitals, among other issuers. The TCJA also portends additional changes to the municipal tax exemption in the future.
Municipal credit and market impacts include the following:
- Smaller Municipal Market. The TCJA will likely contribute to lower municipal supply in 2018 and beyond. The law prohibits advance refundings, which have accounted for 14 percent of issuance, on average, since 2007, per JP Morgan data. The loss of advance refundings is likely to only exacerbate the market’s existing supply shortage. Tepid state and local revenue growth has generally depressed new money issuance since 2010. Structurally lower supply is likely to push both yields and ratios down in the near term. We expect more periods in the coming years during which ratios fall so low that it could make more sense for investment grade investors to purchase Treasuries or taxable municipals – and pay the applicable tax – than to purchase tax-exempt bonds. In our view, muni investors will need to be more cognizant of after-tax income than they have been previously, and should be prepared to cross over to buy Treasuries or taxable munis when it offers more favorable value (see our recent piece, Managing Shifts in Municipal Relative Value).
- Altered Demand Patterns. The TCJA is likely to affect demand in at least three major ways.
- Lowered demand from corporate buyers. First, by reducing the top corporate income tax rate to 21 percent from 35 percent, the law lowers tax-equivalent yields for corporate buyers. As a consequence, U.S. banks (which are 15 percent of municipal holders) and insurance companies (14 percent) may slow or halt their purchases of tax-exempt municipals when the new year begins.2 This could place upward pressure on yields. However, bank and insurance company demand for municipals is as much a function of capital requirements, asset-liability matching and the slope of the yield curve as it is of tax rates, in our view. A downtick in bank and insurance demand is a meaningful risk to monitor, but we believe it is a modest one given the likelihood for lower supply next year.
- Increased demand from individuals. The TCJA limits the state and local tax deduction (SALT) to $10,000 per filer. This is a meaningful curtailment. The average state and local income tax deduction in the U.S. in 2015 was $12,471 for the 44 million taxpayers who claimed it, according to the Tax Policy Center. In New York, the average deduction was $22,169. For many high-income taxpayers in high-tax states, the new limit on the SALT deduction outweighs the benefit provided by slightly lower marginal income tax rates (the TCJA lowers the top marginal rate to 37 percent). Overall, this should increase demand for tax-free income from individuals, as well as lift demand for in-state municipal bonds. All else equal, investors in high-tax states, like New York and California, are likely to demand more compensation to purchase out-of-state bonds.
- Increased demand from AMT payers. The TCJA increases the tax bracket at which the alternative minimum tax (AMT) takes effect. In 2016, nearly 63 percent of taxpayers earning between $500,000 and $1 million were subject to the AMT, per the Tax Policy Center. A large portion of these earners are now more likely to invest in tax-free municipals, and be able to purchase AMT bonds without worry.
- Increased Credit Risks. The TCJA is, on balance, a credit negative for states, local governments, hospitals, and investors overall, in our view. Provisions that could significantly impact municipal credit include:
- Elimination of pre-refunded bonds (pre-res). The law’s prohibition on advance refundings reduces issuers’ financial flexibility by barring them from refinancing bonds inside the standard 10-year call date. The elimination of advance refundings also means that pre-res will eventually disappear, lowering the average credit quality of major bond funds and indexes. Pre-res comprise just under 7 percent of the Bloomberg Barclays Municipal Index.
- New SALT deduction limits. The curtailment of the SALT deduction is likely to crimp public consent of tax increases and lead state and local governments to rely more on user fees and fines to balance budgets in certain high-income, high-tax jurisdictions. Fee- and fine-based revenue tends to provide less revenue stability for governments than broad-based property and income taxes, so budgeting may become more difficult in some jurisdictions. Importantly, the $10,000 limit on the SALT deduction is likely to impact more taxpayers as time goes on. It is not indexed to inflation, but nationwide the average SALT deduction claimed has grown by almost 4 percent per year since 2005, per the Tax Policy Center. Loss of the SALT deduction may also contribute to population flight in some high-tax jurisdictions. Tax policy is not the only reason that residents relocate from New York to Florida, or California to Nevada, but it is certainly relevant.
- Individual tax changes. The TCJA is also likely to increase near-term budget uncertainty in states and cities across the country. All 41 states that impose a personal income tax define their income tax base, in whole or in part, on federal definitions of income. The TCJA expands the personal income tax base by over $400 billion, which suggests that state tax bases will expand as well. Some states may need to adjust-down tax rates early in 2018 to offset the risk they over-collect on a larger tax base. However, because of quirks in how their tax codes dovetail with the federal tax code, other states may experience a decline in their tax bases. The haste with which the TCJA was passed is likely to trickle down to state legislatures in the form of unanticipated revenue issues.
- Federal budget constraints. Higher federal deficits are also a concern. It is widely estimated that the TCJA will cost the federal Treasury $1.5 trillion over 10 years and exacerbate a debt trajectory that threatens budget priorities benefiting municipal issuers. This includes programs like Medicaid and the Highway Trust Fund.
- Tax Exemption Risk. Passage of the TCJA is also a sign that the sanctity of the tax exemption is waning among lawmakers. Recall that the tax exemption was placed at risk in the Obama administration’s last four budgets in the form of a 28 percent cap on tax-exempt interest. Given the federal government’s fiscal condition, investors should not assume the tax exemption maintains its precise shape or form forever.
Hear more of our thoughts on tax reform in a webinar recorded December 20. We will continue to monitor the impacts of tax reform legislation closely and we encourage clients to consult with their financial and tax advisers with any questions or concerns on how these reforms may impact them.
Please contact Breckinridge’s consultant relations team with any questions on this blog via email@example.com.
 Joint Committee on Taxation (JCT) analysis, December 15, 2017. Tax-base expansion estimate based on Breckinridge analysis of JCT’s score of the bill.
 Data based on Fed Flow of Funds data, as of 3Q17.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
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